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Chapter 9Long Term Operating Assets

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Long Term Operating Assets•Purchased, produced, or leased for long

term use by the business•May be tangible or intangible•Capitalized cost may include any cost

incurred to get the asset and get it ready for its intended use▫Purchase price, tax, title, license, delivery,

installation, setup, testing, improvements, clearing, grading, landscaping, etc.

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Tangible vs. Intangible•Tangible long-term assets might include

▫Property, plant, and equipment Buildings, equipment, machinery, furniture, etc.

▫Land ▫Land improvements

•Intangible long-term assets might include▫Patents▫Trademarks▫Copyrights▫Franchise agreements▫Customer lists▫Goodwill

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Basket Purchase• Putnam Company purchases Land, a building,

and equipment for $500,000 cash. If the fair market values of the assets are:

FMV Land $200,000FMV Building 250,000FMV Equipment 150,000Total FMV $600,000

• What amount will Putnam record for each of the assets?

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Relative Fair Market Value• The historical cost principle states that assets

should be recorded at cost, which is value given in an exchange

• In this case the value given is $500,000 while the value received is $600,000

• We will use the fair market values of the assets to help divide up the cost

Land $200,000/$600,000 = 33% (rounded)Building $250,000/$600,000 = 42% (rounded)Equipment $150,000/$600,000 = 25%

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Relative Fair Market ValueContinued

• Use the percentage of each asset’s market value relative to total market value to divide up the cost:

Land 33% x $500,000 = $165,000Building 42% x $500,000 = $210,000Equipment 25% x $500,000 = $125,000

• Record the assets as follows:

Land 165,000Building 210,000Equipment 125,000

Cash 500,000

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Leased Assets•Leases are short-term rental agreements

for use of property▫The lessor is the property owner▫The lessee uses the property in exchange

for rent payments•There are two types of lease accounting,

depending on the nature of the contract▫Operating leases▫Capital leases

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Operating Lease•An operating lease is a simple rental

agreement where the lessee makes rental payments to the lessor in exchange for use of the asset

•The only evidence of an operating lease is the payment

Rent (lease) expense XXX Cash XXX

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Capital Lease

• Certain rental agreements are more complex, or may be a purchase structured to look like a lease

• If the lease is non-cancellable and any one of the following four criteria is met, it will be treated as a capital lease

1. Title will transfer at the end of the lease term, or2. The lease contains a bargain purchase option, or3. The lease term ≥ 75% of the asset’s economic life, or4. The present value of lease payments ≥ 90% of the

asset’s fair market value

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Capital Lease Example•Dental Co. enters into a lease agreement

with Drillers Inc. on 1/1/2009 for the use of special equipment. The lease is non-cancellable and calls for the equipment to be returned to the lessor at the end of the 5 year term. The equipment has a useful life of 6 years. The present value of lease payments is $100,000 and the fair market value of the equipment is $105,000. There is no bargain purchase option. Dental will make payments of $26,380 at the end of each year for five years.

• Is this an operating lease or a capital lease?

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Capital LeaseContinued

•Evaluate the terms of the lease•It is non-cancellable and:

▫Title transfer? No▫Bargain purchase option? No▫Lease life relative to asset life? 5/6 = 83% Yes▫Present value of lease payments to FMV?

$100,000/$105,000 = 95% Yes

•This lease will be recorded as a capital lease

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Capital LeaseContinued

•At the inception of the lease on 1/1/2009 Dental will record the leased asset and related lease liability for an amount equal to the present value of lease payments

1/1 Leased equipment 100,000Lease liability

100,000

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Capital LeaseContinued

•The first payment of $26,380 is made on 12/31/2009, and it includes $10,000 of interest

12/31 Interest expense 10,000 Lease liability 16,380

Cash 26,380

• Each payment will include interest at an amount equal to the interest rate x the outstanding liability

• The remainder of the payment goes toward reducing the liability

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Depreciation

•The systematic allocation of an asset’s cost to expense over the asset’s useful life

•Methods include:▫Straight line (SL)▫Units of production (Units)▫Sum-of-the-year’s digits (SYD)▫Double declining balance (DDB)▫Modified Accelerated Cost Recovery

(MACRS)

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Straight Line Depreciation• Straight line depreciation allocates an equal

mount of depreciable cost to expense each period

• A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life

• Annual depreciation expense:▫ (Cost – Salvage)/Useful life in years▫ (100,000 – 8,000)/10 years = $9,200/year

• Record at December 31st:12/31 Depreciation expense 9,200

Accumulated depreciation 9,200

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Accumulated Depreciation• Accumulated depreciation is a contra-asset• Reported in the balance sheet net to the machine

Machine $100,000Less: Accumulated Depreciation (9,200)Net Book Value $ 90,800

• As a balance sheet account, the balance of accumulated depreciation will carry over from period to period and “accumulate”

• As accumulated depreciation increases, the asset’s net book value decreases

• An asset cannot be depreciated below its salvage value or zero if there is no salvage

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Units of Production• A machine is purchased at the beginning of the

year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life. It produces 110,000 units in year 1 and 106,000 units in year 2.

• Annual depreciation expense for the first two years▫ (Cost – Salvage)/Useful life in units = Cost per unit▫ Cost per unit x units produced = depreciation expense▫ ($100,000 – 8,000)/1,000,000u = $0.092/unit▫ Year 1: $0.092 x 110,000u = $10,120 depreciation

expense▫ Year 2: $0.092 x 106,000u = $9,752 depreciation

expense

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Sum-of-the-Year’s Digits• A machine is purchased at the beginning of the

year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life

• SYD is an accelerated depreciation method where depreciable cost is expensed at a rate of the declining useful life to the “sum of the year’s digits”

• Annual depreciation expense for the first two years ▫ (Cost – salvage) x (remaining life/SYD)▫ SYD = 1+2+3+4+5+6+7+8+9+10 = 55▫ SYD = n(n+1)/2 = (10 x 11)/2 = 55▫ Year 1: ($100,000 – 8,000) x (10/55) = $16,727▫ Year 2: ($100,000 – 8,000) x (9/55) = $15,055

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Double Declining Balance• This is the most accelerated method,

depreciating Book value (the declining balance) at two times the straight-line rate

• Book value = Cost – accumulated depreciation• As accumulated depreciation increases, book

value decreases• Salvage value is not incorporated in the initial

calculation, that would reduce the depreciation expense

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Double Declining BalanceContinued

• A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life

• Annual depreciation expense for the first three years▫ 2 x 1/SL x (cost – accumulated depreciation)▫ Year 1: 2 x 1/10 ($100,000 – 0) = $20,000▫ Year 2: 2 x 1/10 ($100,000 – 20,000) = $16,000▫ Year 3: 2 x 1/10 ($100,000 – 36,000) = $12,800

• Be careful not to depreciate below salvage• This means total accumulated depreciation

cannot exceed $92,000

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Recording Partial Years Depreciation• The year of acquisition and disposal usually

require partial years allocation• Purchases and sales of long-term assets typically

do not occur on January 1• All methods except units-of-production will

require proration• Units of production is based on production, not

time• Some companies apply a first and last year

convention or assumption to simplify▫ One half year in the first and last year regardless of the

date of purchase▫ A full year in the first year and none in the last

regardless of the date of purchase• Watch the dates

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Asset Disposal

•Disposing of long-term assets for more (less) less than book value creates gains (losses)

•To record a disposal▫Depreciation must be recorded and up-to-date▫Remove the cost of the asset from the books▫Remove all related accumulated depreciation▫Record cash or assets received upon disposal▫Debit difference = loss▫Credit difference = gain▫If cash received = book value, no gain or loss

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Asset DisposalContinued

• A machine is purchased at the beginning of the year at a cost of $100,000, has a useful life of 10 years or 1,000,000 units and an $8,000 salvage value at the end of its useful life

• After recording the third year of depreciation (straight-line) the asset is sold for $75,000

• Accumulated depreciation▫ (100,000 – 8,000)/10 x 3 = $27,600

• Record the disposalCash 75,000Accumulated depreciation 27,600

Machine 100,000 Gain on sale 2,600

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Asset Impairment•An impairment represents a decline in the

value of a long-term asset•The value of a long-term asset depends on

the future cash flows (benefit) it will generate

•When an asset is considered impaired▫Future cash flows < book value

•The loss of value equals▫Fair market value – book value

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Recording an Impairment•Dalton Inc. has a piece of equipment with

the following information▫Original cost $400,000▫Accumulated depreciation $130,000▫Expected future cash flows $200,000▫Fair market value $190,000

•Is the asset impaired?•How much is the impairment?•Record the impairment

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Recording an ImpairmentContinued

• Is the asset impaired?▫Future cash flows < book value?▫$200,000 - $270,000 = (70,000) Yes

• How much is the impairment?▫Book value – fair market value▫$270,000 - $190,000 = $80,000 Loss

• Record the impairmentAccumulated depreciation 130,000Loss on impairment 80,000

Equipment 210,000

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Recording an ImpairmentContinued

•Debiting accumulated depreciation removes it from the books

•Debiting the loss records it•Crediting the asset for the difference

between recorded cost and fair market value reduces recorded cost to fair market value

•If future estimates of cash flows show an increase in value, this increase is not recorded

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Review for Exam• Identify different categories of long-term assets• Record a basket purchase• Distinguish between an operating lease and a

capital lease• Record the journal entries for both types of lease• Calculate and record depreciation using

▫ SL, Units, SYD, DDB• Calculate book value• Calculate a gain or loss on disposal and record

the disposal • Calculate and record an asset impairment

May 2010